How Not to Save Housing

In politics it is imperative to be seen as "doing good." The present housing crisis is a case in point, as Congress now seems increasingly intent on aiding millions of homeowners who can't easily pay their mortgages and may face foreclosure. This sort of rescue looks good, even though it is a bad idea and might perversely delay the housing recovery.

No reasonable person takes pleasure from seeing people lose their homes, and Congress is understandably upset. Estimates of defaults in 2008 run up to 2 million. If realized, that would be roughly twice the 2006 level and about 2.7 percent of the nation's 75 million owner-occupied homes. It would be the highest rate since World War II but well below much higher rates during the Great Depression, says economist Kenneth Snowden of the University of North Carolina at Greensboro.

The best-known congressional proposal comes from Massachusetts Rep. Barney Frank, chairman of the House Financial Services Committee. (The Bush administration is reportedly considering a similar plan.) Frank's plan would authorize the Federal Housing Administration to guarantee $300 billion of new home loans to strapped homeowners, allowing them to refinance their mortgages at lower rates and reduce outstanding amounts. Under the plan homeowners who borrowed between Jan. 1, 2005, and July 1, 2007, would be eligible for new loans if their monthly payments of interest and principal exceeded 40 percent of their income—well above a more prudent level of 30 percent.

Existing lenders would have to take a sizable write-down to qualify for having their loans repaid by the government. The FHA would pay the existing lender no more than 85 percent of the property's present appraised value; the FHA would then charge the homeowner for a loan at 90 percent of the appraised value. The extra 5 percent is a cushion against losses. (Example: a $200,000 home with a 100 percent mortgage has already declined 10 percent, to $180,000. The FHA loan repays the existing lender 85 percent of that, about $153,000. The existing homeowner's new loan is at 90 percent of that, or $162,000.)

Everyone wins from this arrangement, say its supporters. Homeowners—some of the victims of deceptive lending—stay in their houses. Neighborhoods don't suffer the potential blight of numerous foreclosures. Housing prices don't go into a free fall, depressed by an avalanche of foreclosures. Although lenders take a loss, the losses are lower than they would be if homes went into foreclosure. That's a costly and lengthy process that can involve losses of 50 percent or more.

The Frank proposal and others like it put politicians on the barricades, trying to protect needy homeowners. The imagery is flattering. But there are two glaring problems, one moral, the other economic.